On my mind The Fed's last call for the punchbowl? - Franklin ...
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CIO VIEWS
On my mind
The Fed’s last call for
the punchbowl?
JUNE 18, 2021 Investing is tough these days—but I’d still rather have my job than the Federal Reserve’s
(Fed). The June policy meeting of the Federal Open Market Committee (FOMC) highlighted
just how complex the central bank’s challenge is.1 In part it’s because the economic
environment has become more complex, but in part it’s the Fed’s own fault.
The Fed’s meeting came off as more hawkish than markets expected: the median Fed
funds forecasts (the “dots”) now show two interest-rate hikes in 2023 (compared
to none in March); the tone on the growth and employment outlook was more upbeat;
the core consumer price index (CPI) forecasts for 2021 and 2022 were raised to 3.0% and
Sonal Desai, Ph.D.
2.1%, respectively.
Chief Investment Officer
Franklin Templeton
But what was most striking was 1) a greater degree of humility in acknowledging the
Fixed Income
uncertainty in an outlook dominated by unprecedented shocks and policy moves; but 2) a
still strong reluctance to start adjusting the policy stance.
Assessing the current inflation rebound is hard. The Fed insists it’s temporary, mostly
due to base effects, and projects inflation coming down on target by next year. But this time
their assessment was a bit more humble. After all, if there is something that can be
foreseen is base effects—we do know the past. And yet, the May US inflation number
surprised to the upside.
INFLATION IS ACCELERATING BEYOND PRE-PANDEMIC PATH
US Consumer Price Index (CPI), seasonally adjusted
January 2018–May 2021
Index
270
256
260
255
250
245
Jan May Sep Jan May Sep Jan May Sep Jan May
2018 2019 2020 2021
Source: Bureau of Labor Statistics (BLS). As of May 31, 2021.I do think there are more durable pressures at work here, as I argued in my LinkedIn news-
letter.2 Stanford’s John Cochrane noted in a recent presentation that if you look at the
price index level, you can see an acceleration that goes beyond making up for the decline of
a year ago. It’s not just going back to the pre-pandemic path, it seems to be heading on
to a steeper one.
The Fed now acknowledges inflation risks are skewed to the upside. But it still sees them as
worth taking to get back to full employment. And here comes another challenge: where
is full employment now? In the short term, we have been focusing on the labor shortages
created in all likelihood by generous enhanced unemployment benefits; even with a
high unemployment rate, employers have a hard time filling vacancies. This is a teachable
moment on the power of incentives, but it should fade over the coming months as the
extra benefits expire.
There is a bigger issue, however: the pandemic has given a serious knock to the labor force
participation rate—the percentage of working-age people who are either working or looking
for a job. During 2017–2019, the US participation rate had begun to slowly reverse its
previous prolonged deep decline. Then between February and April 2020, it collapsed by
more than three percentage points; and after a partial rebound, it’s been treading water for
the last 12 months.
PANDEMIC HAS IMPACTED LABOR FORCE PARTICIPATION
US labor force participate rate (%), seasonally adjusted
January 1991–May 2021
69%
68
67
66
65
61.6%
64
63
62
61
60
59
Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan
1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017 2019 2021
Source: Bureau of Labor Statistics (BLS). As of May 31, 2021.
Or to look at it a different way: between February and May last year, as the economy got
locked down, employment dropped by 21.5 million people; of these, 15.3 million joined
the ranks of the unemployed, and 6.2 million dropped out of the labor force. Since then,
we have reversed three-quarters of the increase in unemployment (11.7 million), but
less than half of the decline in labor force (2.7 million), yielding a two-thirds recovery of
lost employment.
2 On my mind The Fed’s last call for the punchbowl?RETURNING TO WORK?
US jobs recovery (millions of people)
February 2020–May 2020 vs. May 2020–May 2021
Millions of people
20
14.4 15.3
15
10
5 2.7
0
-5
-6.2
-10
-11.7
-15
-20
-25 -21.5
Employed Unemployed Labor force
■ Feb 2020–May 2020 ■ May 2020–May 2021
Source: Bureau of Labor Statistics (BLS). As of May 31, 2021.
In other words, the pace at which people are coming back into the labor force has been
especially disappointing, and flags the risk that some of the decline in labor force participa-
tion might be permanent. Some people might have opted to retire early. Of even greater
concern is the decline in the participation rate for “prime working age” men, those aged
18–54 who constitute the bulk of the labor force: it has recovered only half of the three
percentage point drop recorded at the beginning of the pandemic and has also stagnated for
the past year.
Academics have pored a lot of effort in trying to understand what’s been driving the partici-
pation rate—with mixed results. But the key takeaway is this: over the past 20 years,
something has been pushing participation down, both overall and for prime working-age
men. The decline accelerated between 2009 and 2014, reflecting a slow economic
recovery and wider recourse to social benefits after the global financial crisis; and the hottest
labor market in living memory,(in the run-up to the pandemic) had only managed to boost
participation by less than half a percentage point.
While acknowledging the uncertainty, Fed Chair Jerome Powell expressed confidence that
“we are on a path to a very strong labor market…that shows low unemployment, high
participation.” Let’s hope. But the participation rate has been treading water for the last 12
months. If its recovery proves as slow and limited as it was the last time around, full
employment might be depressingly closer than we thought.
When Powell says we’ll get back to low unemployment and high participation, does he mean
that the Fed’s full employment target is a 3.5% unemployment rate with the participation
rate back to pre-pandemic levels above 63%? That might be well be a very unrealistic target.
The Fed now acknowledges the upside inflation risks and Powell said they have started to
talk about an eventual tapering of asset purchases—though they still want to see substantial
further progress towards their goals. This week’s meeting was an important step forward;
the change in the inflation forecasts and interest rate expectations by FOMC members have
shifted the tone of the discussion, and reminded investors that down the line, tapering is
going to happen. But getting the timing right will be hard, given the uncertainty in inflation
3 On my mind The Fed’s last call for the punchbowl?and employment trends. The complicating factor which makes this a very high-stakes
game is the exceptionally loose stance of monetary policy—and this is the Fed’s own doing.
If the recovery keeps roaring and inflation pressures persist, monetary policy will look
increasingly out of line with fundamentals; executing a smooth course correction without
either spooking investors or letting the economy overheat too much will be the hardest
high-wire balancing act we’ve seen in a long time. The markets are watching.
Meanwhile, even as 10-year US Treasury (UST) rates have nervously moved up on the Fed’s
news, the challenge for fixed income investors remains how to generate yield without
being forced further and further out on the risk spectrum. It can be done. Funds have kept
coming into the municipal bonds market, and the Financial Times warns that “junk”
municipal bonds in particular are attracting too much interest.3 But if you do your homework,
the municipal bond universe offers plenty of opportunities for attractive yield pickup
on strong quality issuers—our Franklin Templeton Municipal Bonds team has its own track
record to prove how deep research in this area pays off.
The high yield corporate bond sector also offers some very interesting opportunities, despite
the continued compression of spreads. The average quality of the index has risen, as the
pandemic flushed out some of the weakest credits and at the same time has pulled in some
“fallen angels” from the investment grade level. BB-rated companies now account for
about 54% of the Bank of America Merrill Lynch High-Yield Index; that’s a five percentage
points increase from early last year.4 When you put that together with a strong economic
growth outlook, the high-yield sector looks quite attractive—always with a watchful eye to
individual name quality, of course.
And of course, one of our underlying main strategy themes remains to limit duration:
whether the Fed ratchets up its rhetoric further in the coming months or not, risks to
inflation and yields seem squarely skewed to the upside. The Fed sounds confident and in
control, but still, I would not want to be in their shoes.
Endnotes
1. Source: US Federal Reserve. June 15-16, 2021 FOMC meeting.
2. Source: Mind over Markets LinkedIn Newsletter, by Sonal Desai. “The UBI-quitous inflation question”, June 9, 2021.
3. Source: Financial Times. “US investors hunt for yield in junk-rated municipal debt”, June 16, 2021.
4. Source: ICE Data Indices, LLC. As of May 31, 2021. Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges.
WHAT ARE THE RISKS?
All investments involve risks, including possible loss of principal. The value of investments can go down as well as up,
and investors may not get back the full amount invested. Bond prices generally move in the opposite direction of interest
rates. Investments in lower-rated bonds include higher risk of default and loss of principal. Thus, as prices of bonds in
an investment portfolio adjust to a rise in interest rates, the value of the portfolio may decline. Changes in the credit
rating of a bond, or in the credit rating or financial strength of a bond’s issuer, insurer or guarantor, may affect the
bond’s value. Actively managed strategies could experience losses if the investment manager’s judgment about
markets, interest rates or the attractiveness, relative values, liquidity or potential appreciation of particular investments
made for a portfolio, proves to be incorrect. There can be no guarantee that an investment manager’s investment
techniques or decisions will produce the desired results.
4 On my mind The Fed’s last call for the punchbowl?IMPORTANT LEGAL INFORMATION This material is intended to be of general interest only and should not be construed as individual investment advice or a recommendation or solicitation to buy, sell or hold any security or to adopt any investment strategy. It does not constitute legal or tax advice. The views expressed are those of the investment manager and the comments, opinions and analyses are rendered as of June 18, 2021 and may change without notice. The information provided in this material is not intended as a complete analysis of every material fact regarding any country, region or market. All investments involve risks, including possible loss of principal. Data from third party sources may have been used in the preparation of this material and Franklin Templeton (“FT”) has not independently verified, validated or audited such data. 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